S&P: CLO Upgrade Ratio Still Healthy, but Pressure Mounts

Standard & Poor’s upgraded far more collateralized loan obligations than it downgraded in the second quarter of 2016, even as the credit quality of assets in these investment vehicles continued to deteriorate.

The rating agency said last week it upgraded 149 tranches of senior, mezzanine or subordinate notes across 49 CLOs. By comparison, it downgraded just 13 tranches of six CLOs. This was despite the fact that S&P downgraded more than three times the leveraged loans in CLO portfolios than it upgraded. The default rate on leveraged loans also climbed to a six-year high in June.

CLOs issue notes carrying varying levels of seniority, typically ranging from ‘AAA’ to unrated, using the proceeds to acquire a portfolio of below investment grade corporate loans. Income from the loans is paid to first to the most senior noteholders first, then to subordinate noteholders, with holders of the unrated equity last in line (if anything remains).

In the first half of the year, CLOs in their revinvestment saw their exposure to assets rated ‘CCC+’ or below increase by an average of 2% - a major factor in the deterioration of CLOs’ overcollateralization ratios by just under 1% on average, according to the report.

Overcollateralization is a common credit-enhancement feature of portfolios, in which managers post additional collateral above the notional value of notes for principal protection in the vent of a drop in asset valuations.

The deterioration of assets, such as in distressed debts from the energy field, has left an average CLO subordinate OC cushion of approximately 4% at the end of June, according to S&P. The tightest overcollateralization levels have typically less than 3-4% of par of a CLO’s assets to par of a CLO’s debt to maintain investor principal protection in the event of a drop in asset valuations.

The diversity in CLO assets helped protect portfolios from problem sectors like energy by limiting individual portfolios from one particular exposure (CLOs held only 1.2% of defaulted energy assets at year’s end 2015).

But a number of major 2016 energy defaults like Arch Coal, Paragon Offshore and Seventy Seven Energy made an impact on CLOs with an “above-average” exposure to problem assets. S&P reports that the six CLOs with mezzanine and subordinate notes downgraded by one to three notches in the second quarter had these issues.

Four CLOs currently have one or more subordinate tranches on a negative credit watch with S&P: ICE 1: EM CLO, ICE Global Credit CLO, Mountain Hawk I CLO, and Mountain Hawk II CLO.

The upgrades were split among portfolios that had entered their reinvestment period (25) and those that paid down their senior notes (24). Most of the upgrades occurred for the higher rated mezzanine tranches, those rated ‘AA’ to ‘A.’

S&P likewise upgraded 74 tranches of 24 CLOs that have entered repayment. “However, the growing defaulted buckets and declines in portfolio diversification are starting to put pressure on the subordinate notes of some amortizing CLOs, despite the senior note pay downs,” the report stated.

S&P withdrew ratings on 126 tranches of 45 U.S. CLOs issued before the financial crisis as the result of pay downs. These are deals that are being paid off as they reach maturity, but also part of a trend toward optional redemptions that S&P expects to continue for CLO 1.0s and 2.0s.

The 12-month trailing corporate default rate climbed to 4.3% at the end of June from 3.8% at the end of the first quarter – the highest rate since 2010, and is projected to increase to 5.3% by next March, according to S&P. But CLOs have limited exposure, the report noted. Of the 29 companies that defaulted in the second quarter, CLOs only had exposure to 15 of them.

The number of U.S. corporate defaults has more than doubled to 71 from 34 at the midway point of 2015, and has already surpassed the full-year 2015 total of 66. Globally, S&P’s measure of “weakest links” (or firms rated ‘B-’ or lower with negative outlooks or negative credit-watch standing) rose to a “historical high” of 245 in June.

The largest exposure was with the 142 CLOs exposed to Fieldwood Energy, which underwent a distressed exchange in June.

Downgrades nearly tripled the number upgrades in the corporate spec-grade sector (162 to 67), but the downgrade to upgrade ratio was much lower within widely held CLO assets. Only 34 of the most widely held CLO assets had a rating action – 11 obligors were given debt ratings upgrades, while six were placed on a positive credit watch. Fifteen were downgraded and two placed on negative credit watch.